Marijuana stocks catch fire

A representative from Sky High smokes from vaporizer during the Champs Trade Show in Las Vegas on Jan. 21. The trade shows attracts distributors of smoking paraphernalia and merchants from around the country. Photographer: Jacob Kepler/Bloomberg

A representative from Sky High smokes from vaporizer during the Champs Trade Show in Las Vegas on Jan. 21. The trade shows attracts distributors of smoking paraphernalia and merchants from around the country. Photographer: Jacob Kepler/Bloomberg

A representative from Sky High smokes from vaporizer during the Champs Trade Show in Las Vegas on Jan. 21. The trade shows attracts distributors of smoking paraphernalia and merchants from around the country. Photographer: Jacob Kepler/Bloomberg

Marijuana stocks are on fire this year, with plenty of investors suddenly willing to risk being burned.

Shares in almost any company with the slightest association to marijuana got a huge lift in late 2012 after voters in Colorado and Washington legalized recreational use. Twenty states including California allow medical use.

Practically all of the stocks in this sector — including two based in San Diego County — are lightly regulated and traded over the counter, so they lack the transparency offered by major exchanges.

Most have little revenues and no profits; some have no assets or sales at all. At best, these stocks are highly speculative.

Last month the Financial Industry Regulatory Authority reissued an August statement titled “Marijuana Stock Scams”: “We are reissuing this alert to warn investors not only about the potential for fraud in this arena, but also to reiterate the risks of investing in thinly traded companies about which little is known,” FINRA said.

But the warning did little to dampen investor enthusiasm.

Stock prices and trading volume have surged again this year with press accounts of long lines outside pot shops in Colorado, which allowed sales to anyone over 21 starting Jan. 1. And Tuesday the U.S. Senate passed a farm bill that, if signed by the president, will legalize the cultivation of hemp, a nonintoxicating cousin of marijuana that produces valuable fibers and health supplements.

This appears to have sparked a speculative frenzy, particularly among small investors: The most active stock Tuesday for customers of Fidelity Investments — ahead of Facebook and Apple — was Hemp Inc., which gained 54.5 percent in value to 26 cents a share.

At 21st on the Fidelity list, ahead of health-care giants Pfizer and Johnson & Johnson, was Medical Marijuana Inc., a San Diego company that reported about $604,000 in total sales for the third quarter.

To optimists, the eventual demise of marijuana prohibition looks like a historic opportunity.

A report funded by The ArcView Group, an investment company, estimated the U.S. market in legal marijuana market at $1.44 billion in 2013, with growth projected at 64 percent to $2.34 billion in 2014 and 600 percent to $10 billion in five years.

But venture capitalists say good investment opportunities are few and far between. A booming market is one thing; earning consistent profits is quite another.

As you might expect of an industry that until very recently was illegal, many pioneers are long on enthusiasm but short on operating discipline.

A competitive shakeout will certainly cure such shortcomings over time. After all, U.S. railroads went broke throughout the 1800s. And the Internet boom of the late 1990s was lousy with profitless startups that wiped out shareholders.

Then again, marijuana is an agricultural product. Prices in the ag sector tend to converge near the cost of production over the long haul.

And they don’t call it “weed” for nothing; marijuana is laughably easy to grow. A farming or accessories manufacturing firm will have a hard time building the type of wide moat against competitors required to reward long-term shareholders.

I should disclose here that I’m a value investor. I own no marijuana stocks, because I generally look for a decade or so of steadily growing returns on invested capital before I will buy a stock.

But even if you are more inclined to speculation, there’s plenty of reason to go slow in this sector.

The industry giant is Medbox Inc., based in West Hills, which makes a vending machine that dispenses medical marijuana.

Medbox listed about $259,000 in profits and $6.1 million in shareholders equity in the third quarter. But investors have bid its total market value to a staggering $535 million. That’s down from more than $1 billion last year.

Granted, the MedBox is a cool device, using a fingerprint reader to make sure juveniles don’t buy pot. But still, it’s a vending machine.

Medical Marijuana, the San Diego company, also has real products for sale, ranging from cannabis chewing gum to hemp-based beauty and pet products. I visited the company’s booth Saturday at a U-T sponsored exhibition, where salespeople fielded questions from consumers about a wide variety of products on display.

The company is growing, but still very much in startup mode, reporting a loss of $86,463 in the third quarter on ordinary income. Yet it posted net income of $7.9 million after selling assets of a marijuana-related company; most of the proceeds came in the form of stock, with little cash changing hands.

And the company disclosed in August that it had received an inquiry from the Securities and Exchange Commission. The agency requested documents about current and former management, communications with government agencies, operations and “other matters.” The company said it was fully cooperating with the inquiry.

In July former directors filed a suit that alleges fraud in the purchase of a subsidiary. And in September 2012, CEO Michael Llamas stepped down after a federal indictment charged that he was involved in a Ponzi scheme and mortgage fraud that was unrelated to Medical Marijuana Inc.

I wanted to check on the status of the SEC inquiry, but interim CEO Michelle Sides did not return my calls this week.

Another public company, Mentor Capital Inc., lists a post office box in Ramona as its official address. Financial disclosures on its website list no revenues, no profits, and $720,062 in shareholders equity.

Yet on Jan. 17, Mentor’s stock increased nearly 750 percent in about two hours, jumping from 22 cents per share to $1.90 as 691,000 shares changed hands over the counter. Previous trading days had between zero and 11,000 shares in volume.

The stock closed Tuesday at $1.91 per share on volume of 71,000 shares.

Mentor’s soaring stock price came after CEO Chester Billingsley issued a news release on the Business Wire service saying the company had reached a deal to buy HempCon Inc., a Hacienda Heights firm that holds marijuana trade shows.

But there was no such deal, says Edwin Kwong, HempCon’s owner.

“Mentor Capital did approach me at one point, and we had a couple of discussions,” Kwong told me Tuesday. “But nothing was firm; nothing was signed.”

Kwong said he rejected Mentor’s overtures after concluding that Billingsley had no cash and was merely offering a future investment with uncertain prospects.

Twelve days later, Billingsley issued a release saying Mentor’s board had rejected the deal. But this release was posted to the OTC Markets website, and didn’t go out on Business Wire, which is distributed widely and picked up by major investor websites.

In a phone conversation, Billingsley had no explanation for why he used Business Wire for the first release and subsequent releases, but not the one with presumably negative news.

Billingsley, who has operated businesses ranging from tanning salons to oil and gas partnerships over the years, said his plan is to build a portfolio of companies in the red-hot marijuana sector.

He said he has 1,000 “accredited investors” lined up to contribute capital. All he lacks are the deals, Billingsley said. But he said he has contacted 55 CEOs of marijuana companies to discuss possible deals, with 18 discussing terms.

“I’ve taken all of my shares and put them in escrow, because I wanted to distance myself from the pump-and-dump activity that FINRA and others have warned about recently,” he said.

Billingsley said the terms of that escrow call for him to announce his stock sales first, in a news release, after which he can sell.